2.3 Types of Main Markets and Market Participants
Key Takeaways
Money markets trade short-term debt (normally up to one year) including Treasury bills, commercial paper, certificates of deposit and repos, used by banks and the Bank of England to manage liquidity.
Capital markets trade long-term debt and equity — gilts, corporate bonds, and listed shares — funding government and corporate investment.
Derivatives markets (futures, options, swaps) transfer risk and price future expectations; FX markets exchange currencies; commodity markets trade physical and forward metals, energy and agricultural products.
Main participants are banks, building societies, insurers, fund managers, brokers, market makers and clearing houses, each with a distinct economic role.
Central counterparties such as LCH, Euronext Clearing and ICE Clear become buyer to sellers and seller to buyers on cleared trades; they reduce counterparty risk while concentrating risk in the CCP.
Section 2.2 looked at venues. This section looks at what is traded and who trades it. You should be able to identify each market type, the instruments it trades and the participants who operate in it.
Money Markets
Money markets trade short-dated debt instruments with original maturities of up to one year. They are the working-capital market of the financial system.
| Instrument | Issuer | Purpose |
|---|---|---|
| Treasury bills | UK Debt Management Office on behalf of HM Treasury | Short-term government funding; discount instruments |
| Commercial paper | Corporates and banks | Unsecured short-term corporate borrowing |
| Certificates of deposit (CDs) | Banks | Negotiable receipts for time deposits |
| Repurchase agreements (repos) | Banks, building societies, Bank of England | Borrowing against collateral; the Bank's sterling monetary operations use repos |
The Bank of England's sterling monetary framework operates in money markets. Reserve remuneration and lending operations help keep short-term market rates aligned with Bank Rate, the policy rate set by its Monetary Policy Committee. SONIA (the Sterling Overnight Index Average) is a transaction-based measure of sterling overnight borrowing rates, not a separate policy target. Money-market rates are the foundation for the pricing of mortgages, savings and many derivatives.
Capital Markets
Capital markets trade long-term debt and equity — instruments with maturities over one year and shares with no fixed maturity.
- Gilts are UK government bonds issued by the DMO. They provide a benchmark for sterling bond yields and have low sovereign credit risk, but their market prices can fall when yields rise.
- Corporate bonds are debt issued by companies, typically 3–30 years, with credit risk priced as a spread over gilts.
- Equities are ownership shares in companies, which may be listed or unlisted. Voting and dividend rights depend on the share class; dividends and capital gains are not guaranteed, and investors can lose their investment.
Capital markets fund long-term investment — government infrastructure, corporate expansion, homeowner borrowing via mortgage-backed securities — and they price long-term risk.
Derivatives Markets
Derivatives are contracts whose value derives from an underlying asset, index or rate. The main types are:
- Futures — exchange-traded contracts to buy or sell at a future date at a price set today (e.g. ICE Brent crude futures).
- Options — the right, but not the obligation, to buy (call) or sell (put) at a strike price.
- Swaps — agreements to exchange cash flows, most commonly interest-rate swaps (fixed for floating) used by UK banks to hedge mortgage books.
- Forwards — bespoke, OTC versions of futures, used in FX and commodities.
Derivatives are used to hedge (a UK exporter locking in a euro-sterling rate) or to speculate (a fund taking a directional view without owning the underlying). They can create leverage and contagion, which is why they are regulated and centrally cleared where possible.
Foreign Exchange Markets
FX markets exchange currencies, and London is a major trading centre. Spot FX normally settles within two business days, with the precise settlement date depending on the currency pair and market convention. Forwards and swaps can hedge future currency exposures. The Bank of England publishes daily spot exchange rates for information; these are not official London fixings. Applicable regulation depends on the product and activity, while the FX Global Code provides good-practice principles for the wholesale market.
Commodity Markets
Commodity markets trade physical and forward contracts in metals (LME), energy (ICE Brent crude, natural gas), soft commodities (cocoa, coffee, sugar) and agricultural products. They allow producers (miners, oil majors, farmers) to hedge price risk and consumers (airlines, manufacturers) to lock in input costs.
Market Participants
The main participants in UK markets each play a distinct role:
| Participant | Role |
|---|---|
| Banks | Take deposits, make loans, operate payment systems, trade in wholesale markets |
| Building societies | Mutual deposit-takers specialising in retail funding and mortgages |
| Insurers | Pool and underwrite risk; long-term insurers are major institutional investors |
| Fund managers | Manage pooled savings (pensions, ISAs, OEICs, investment trusts) on behalf of investors |
| Brokers | Arrange or execute trades; some also provide investment advice where authorised |
| Market makers | Quote continuous bid and ask prices and trade from their own books, supplying liquidity |
| Clearing houses | Interpose a central counterparty and manage obligations through netting, margin and default resources |
Central counterparty (CCP) clearing
A central counterparty (CCP), such as LCH, Euronext Clearing (formerly CC&G) or ICE Clear Europe, stands between the two sides of a cleared trade. Euronext Clearing belongs to Euronext. The original bilateral exposure is replaced by exposure to the CCP. Netting, collateral and default-management resources reduce counterparty credit risk, but do not eliminate it. Clearing also concentrates risk in the CCP, so its resilience and supervision matter. The Bank of England supervises UK CCPs; an overseas CCP has its own home regulatory framework and may also need UK recognition.
Putting It Together
For example, a client buying a listed share within a Stocks and Shares ISA sends an order through a broker to a trading venue. Where the trade is centrally cleared, a CCP manages the obligations before securities and cash settle through the relevant settlement arrangements. A custodian can hold the resulting securities for the client. These are separate trading, clearing, settlement and custody functions; not every investment follows the same route.
Key Takeaways for the Exam
- Money markets: short-term debt (Treasury bills, CDs, repos, commercial paper), used for liquidity management.
- Capital markets: long-term debt and equity, used for investment funding.
- Derivatives transfer risk and create leverage; central clearing reduces counterparty risk but concentrates systemic risk in CCPs.
- FX markets exchange currencies; check the pair's settlement convention and distinguish indicative published rates from an execution price.
- Market participants: banks, building societies, insurers, fund managers, brokers, market makers, clearing houses — each with a defined economic role.
Sources: Bank of England market operations, SONIA, exchange rates, BIS spot FX definition, Euronext Clearing ownership, and Bank of England explanation of CCP risk.
Which instrument would a UK bank most likely use to borrow from the Bank of England against high-quality collateral under the sterling monetary framework?
A 30-year gilt
A repurchase agreement (repo)
A FTSE 100 equity option
A commercial paper issue
After a trade is executed on an exchange, a clearing house interposes itself between buyer and seller. What is the main benefit, and what new risk does it create?
Replaces counterparty risk with market risk; removes the need for collateral.
Reduces price volatility; concentrates market-making activity in the CCP.
Transfers investors’ market losses to the CCP; pools those losses across members.
Reduces bilateral counterparty credit risk; concentrates exposure and systemic risk in the CCP.
Which combination best describes the five main types of market discussed in this section?
Money, capital, derivatives, FX, commodity
Primary, secondary, retail, wholesale, institutional
Auction, dealer, OTC, exchange-traded, hybrid
Equities, bonds, gilts, cash, property
Sections you finish are checked off in the contents.